IEDA 3230: Engineering Economy

Comparing Engineering Project (deterministic models)

Agenda

- Evaluating multiple mutually exclusive investment

opportunities to select the best one

- Evaluating multiple projects to select a subset among them

 Motivating Example

A taxi license owner wants to buy a new car to use as a taxi.

He has to choose between the following:

5-passenger Toyota Crown Comfort

Cost: HK$ 250,000 4-passenger Toyota Prius
Cost: ~HK$ 280,000

What other information will he need

to decide which one to buy?

New Toyota hybrid taxi

[images source: wikipedia.com]
Cost: HK$ 300,000
Motivating Example

How can you select the best credit card, given:

- Yearly fee
- Interest rate charges
- Cashback terms (i.e. what % of your spending is credited back to you)

[source: moneyhero.com.hk]
Mutually exclusive alternatives

Considerations:
Investments
Revenues
Costs
Useful life of project
What criterion is used for comparison
A common practice is:
- Set the choice with the minimum initial investment
with acceptable IRR as base alternative
- For each of the remaining, check if additional
investment is justifiable
 Role of MARR in comparisons

Which cash flow, A or B, is more attractive?

A = 22000 A = 26225

A B
60000 73000

• If MARR=10%:
• PWA=−60000+22000(P/A,10%,4)=9,738: Base Alternative
• PWB=−73000+26225(P/A,10%,4)=10,131: PWB is preferred
• If MARR=15%:
• PWA=−60000+22000(P/A,15%,4)=2,809: Base Alternative
• PWB=−73000+26225(P/A,15%,4)=1,872: PWB is NOT preferred
• If MARR=11.39%:
• PWA=−60000+22000(P/A,11.39%,4)=7,689: Base Alternative
• PWB=−73000+26225(P/A,11.39%,4)=7,689: PWB is the same as Base
Identical useful lives: example

Assuming MARR = 10%

Alternative A Alternative B
Capital investment 60,000 73,000
Annual revenue 22,000 26,225
IRR 17.30% 16.26%
PW (MARR) 9738 10131

Compare the IRR directly?

– Both are acceptable (PW(10%) > 0)
– Alternative A seems better by comparing IRR
– Alternative B seems better by comparing PW [Why?]
 MARR vs IRR

@ IRR @ MARR

60000 IRR method PW method

60000

Notice that the IRR method  any (net) income is re-invested @ 17.3%
but the PW method  any (net) income is reinvested @ MARR (=10%)
More on IRR

IRR can only tell whether an alternative is acceptable or not,

but not to directly compare alternatives

The IRR of the incremental net cash flow can be used to

compare alternatives
RULE: The additional investment is justified only if the IRR for the
incremental net cash flow is greater than MARR

Alternative A Alternative B B-A

Capital investment 60,000 73,000 13000
Annual revenue 22,000 26,225 4225
IRR 17.30% 16.26% 11.39%
PW (MARR) 9738 10131 393
Correct usage of IRR in comparing alternatives
Alternative A Alternative B B-A
Capital investment 60,000 73,000 13000
Annual revenue 22,000 26,225 4225
IRR 17.30% 16.26% 11.39%
PW (MARR) 9738 10131 393

The cash flow for Alternative B is divided into two sub-flows

One is the base investment: Alternative A

The other (B-A) requires additional investment

it generates a net revenue (= profit, + or -)

B is better is better if these extra profits are acceptable.

IRR – how to compare multiple alternatives

1. Arrange all alternatives in increasing order of their

investments
Eliminate alternatives with IRR<MARR
The alternative with the least investment is the base
alternative

2. Start with the base alternative as the current best

3. Repeatedly compare the current best alternative

with the next alternative
If the IRR of the incremental net cash flow is greater than
MARR, choose the next alternative as the current best
alternative
 IRR method for multiple alternatives: Example

Life of each project: 10 years; MARR: 10%

A B C D E F
Investment 900 1500 2500 4000 5000 7000
Annual Income 150 276 400 925 1125 1425
IRR(%) 10.6 13.0 9.6 19.1 18.3 15.6

Step 1: Project C is rejected  IRR < MARR

Step 2: Base investment = A  InvestmentA < InvestmentB, D, E, F
Step 3.1: Compute IRR's:
Net incremental income of B over A:
For B-A: {-600, 126, 126, …}; IRR = 16.4% > MARR
 B becomes the current best
…
 IRR method for multiple alternatives: Example (cont.)

Life of each project: 10 years; MARR: 10%

A B C D E F
Investment 900 1500 2500 4000 5000 7000
Annual Income 150 276 400 925 1125 1425
IRR(%) 10.6 13.0 9.6 19.1 18.3 15.6

[Step 3.1: B is the current best]..

Step 3.2: Net incremental income of D over B:
For D-B: {-2500, 649, 649, …}; IRR = 22.6% > MARR
 D becomes the current best
…
 IRR method for multiple alternatives: Example (cont.)

Life of each project: 10 years; MARR: 10%

A B C D E F
Investment 900 1500 2500 4000 5000 7000
Annual Income 150 276 400 925 1125 1425
IRR(%) 10.6 13.0 9.6 19.1 18.3 15.6

[Step 3.2: D is the current best]..

Step 3.3: Net incremental income of E over D:
For E-D: {-1000, 200, 200, …}; IRR = 15.1% > MARR
 E becomes the current best
…
 IRR method for multiple alternatives: Example (cont.)

Life of each project: 10 years; MARR: 10%

A B C D E F
Investment 900 1500 2500 4000 5000 7000
Annual Income 150 276 400 925 1125 1425
IRR(%) 10.6 13.0 9.6 19.1 18.3 15.6

[Step 3.3: E is the current best]..

Step 3.4 Net incremental income of F over E:
For F-E: {-2000, 300, 300, …}; IRR = 8.1% < MARR
 Reject F

By the Incremental IRR Rule, we accept F.

You can verify that alternative E will have the highest PW @10%
Comments on the Incremental IRR method

Suppose we compared all acceptable alternatives using A as a base

alternative?

A B C D E F
Investment 900 1500 2500 4000 5000 7000
Annual Income 150 276 400 925 1125 1425
Incremental investment 600 1600 3100 4100 6100
Incremental income 126 250 775 975 1275
Incremental IRR 16.4 9.1 21.4 19.9 16.3

If incremental IRR is used relative to alternative A, then alternative

D is the best (different from PW method)
 Comments on the Incremental IRR method (cont.)

Incremental return comparison methods are popular in industry

- It is based on whether an additional investment can be justified or not

- It is conservative (in terms of spending): invest only if you can earn more

- It supports growth: if a larger investment is acceptable, then we should invest

Other methods:
- Cost only comparison:
For each alternative, find the IRR relative to the base investment (i.e. using
incremental return approach) by considering only the investment costs,
operational costs, and salvage value
Comparing alternatives with different useful lives

Alternative 1:
– You can invest $100 in a project
• MARR=3%
– After one year, you will receive $115
• IRR=15%
• PW=111.65

Alternative 2:
– You can extend Alternative 1 to 2 years and receive $121
• IRR=10%
• PW=114.05

Which option do you want to choose?

Can we compare 111.65 & 114.05 directly?
Background: problems with different useful life comparison

1. How can we justify the differences in the PW's that

are computed over different periods?
2. How can justify a machine/facility that is relatively
more expensive, but has longer useful life?

General guideline for such comparisons:

We need to use a study period which allows a fair
comparison of alternatives
How to make a fair comparison (cont.)

Repeated investment model:

Assume that at the end of each project, it can be re-invested
again on the same terms (i.e. same cost, return etc.)

For all alternatives with different useful lives, the study

period is the least common multiple for the lives of all
alternatives
e.g. If Alternative A has useful life 4 years, an Alternative B
has useful life 6 years, we use a study period of 12 years.
How to make a fair comparison (cont.)

Co-terminated model:
In this case, the study period is specified, and all projects will
be evaluated over this period.
 We must account for additional salvage value of any
alternative that has useful life longer than study period.

e.g. If Alternative A has useful life 4 years, an Alternative B

has useful life 6 years, we use a study period of 12 years.

What if study period is longer than the life of some alternative?

Repeated investment method: example

A B
Capital investment 3500 5000
Annual cash flow 1255 1480
Useful life (years) 4 6

1255
MARR = 10%
4 8 12

3500

1480
MARR = 10%
6 12

5000
Repeated investment method: example

4 6

• PW method (PW for 12 years, MARR=10%)

PWA= −3500−3500(P/F,10%,4)−3500(P/F,10%,8)
+1255(P/A,10%,12)=1028
PWB= −5000−5000(P/F,10%,6)+1480(P/A,10%,12)
= 2262 > PWA
Alternative B is better

• AW method
– To calculate AW, based on one life cycle for each alternative is
sufficient [Why?]
AWA=−3500(A/P,10%,4)+1255=151
AWB=−5000(A/P,10%,6)+1480=332 > AWA
Repeated investment method: example (cont.)

4 6

We may also use the IRR method (incremental model) for comparing the
alternatives. Here the base alternative is A [Why?]

225
Incremental
cash flow
1500 4775

Incremental cash flow

– (-1500,225,225,225,3725,225,-4775,225,3725,225,225,225,225)
– IRR is 26.03% > MARR  B is better.
Co-terminated model: example

A B
Capital investment 3500 5000
Annual cash flow 1255 1480
Useful life (years) 4 6

Studying period: 6 years

1255
4 6
For A: convert FW4 to FW6 at MARR
3500
1480

5000
Co-terminated model: example (cont.)
1480
1255
4 6

3500
5000

• For alternative A
FWA,4= −3500(F/P,10%,4) + 1255(F/A,10%,4)
FWA,6= FWA,4(F/P,10%,2) = 847

• For alternative B
FWB,6= −5000(F/P,10%,6) + 1480(F/A,10%,6) = 2561
Co-terminated model: example (cont.)

Suppose we use the incremental IRR method for this case

Studying period: 6 years

1255 A 1480 B

3500 5000

225 1480
IRR for incremental
cash flow:
Incremental cash flow 23% > MARR
1500
Selecting a subset of projects from the alternatives

Considerations:

• Relationship among multiple alternatives/projects

– Mutually exclusive
– Independent
– Contingent: project p can be selected only if project q is
selected

Method:

– Find the combinations of all feasible choices

– Each combination is mutually exclusive to others
– We need to choose one from the combinations rather
than individual projects
Combinations of contingent projects

N independent projects  how many combinations (subsets)?

Five projects B1, B2, C1, C2, D

B1, B2: mutually exclusive, not contingent on any others
C1, C2: mutually exclusive, contingent on the acceptance of B2
D: contingent on the acceptance of C1
How many combinations?

Combination B1 B2 C1 C2 D Explanation
1 0 0 0 0 0 Accept none
2 1 0 0 0 0 Accept B1
3 0 1 0 0 0 Accept B2
4 0 1 1 0 0 Accept B2 and C1
5 0 1 0 1 0 Accept B2, C2
6 0 1 1 0 1 Accept B2, C1, D

Any other possible combinations?

 Combination of contingent projects: example (cont.)

Time period
Project 0 1 2 3 4 PW (MARR=10%)
B1 -50 20 20 20 20 13.4
B2 -30 12 12 12 12 8.0
C1 -14 4 4 4 4 -1.3
C2 -15 5 5 5 5 0.8
D -10 6 6 6 6 9.0

Project C1 cannot be pre-eliminated even though PWC1< 0 [Why?]

 Combination of contingent projects: example (cont.)

Cash flow for each combination:

Time period
Combination 0 1 2 3 4 PW (MARR=10%)
1 0 0 0 0 0 0
2 (B1) -50 20 20 20 20 13.4
3 (B2) -30 12 12 12 12 8.0
4 (B2,C1) -44 16 16 16 16 6.7
5 (B2, C2) -45 17 17 17 17 8.8
6 (B2,C1,D) -54 22 22 22 22 15.7

If we have unlimited budget: (B2, C1, D) is the best

Which combination is best if maximum initial budget is 48 ?
Combination of projects: General methodology

The project combination problem can be formulated

as an optimization problem.

There are n alternatives

For each alternative, i ( i = 1, .., n)
PWi is known for a given MARR
Vi is the initial investment
The maximum available initial budget = V
The decision variables are Xi :
Xi =1 if alternative i will be chosen, and
Xi = 0 if alternative i will not be chosen
Combination of projects: problem formulation

Objective function: to maximize total PW among all choices

Constraints:
– Total investment cannot exceed the maximum budget
– Each Xi has to be 0 or 1

n
max  X i PWi
i 1
n
s.t. Vi X i  V
i 1

X i  {0,1}
Combination of projects: problem formulation (cont.)

Exclusive constraint
– Projects i and j are mutually exclusive 
we need another constraint: Xi + Xj ≤ 1
(we need such a constraint for each pair of mutually
exclusive projects)

Contingent constraint
– Project i can be selected only if project j is selected 
we need another constraint: Xi ≤ Xj
(we need such a constraint for each pair of contingent
projects)
Combination of projects: Example

max 13.4 X B1  8 X B 2  1.3 X C1  0.8 X C 2  9 X D total PW

s.t. X B1  X B 2  1 B1, B2 are mutually exclusive

X C1  X C 2  1 C1, C2 are mutually exclusive

X C1  X B 2 C1 contingent on B2
X C 2  X B2 C2 contingent on B2
X D  X C1 D contingent on C1

50 X B1  30 X B 2  14 X C1  15 X C 2  10 X D  48 max budget

X B1 , X B 2 , X C1 , X C 2 , X D {0,1} binary Xi

How to solve? Use a solver, e.g. Matlab, Excel,..

Summary

- We saw several methods of comparing the economic acceptability of

multiple projects
- In selecting a subset of multiple alternatives, we need to use
numerical solvers: we saw a simple Integer Programming model

Acknowledgements:
1. Most of the lecture notes for this course are adapted from those of Prof Xiangtong Qi
2. Course text: Engineering Economy by Sullivan, Wicks, Koelling

Next: Investment under uncertainty